I. PURPOSE

This notice announces the intent of the Treasury Department (Treasury)
and the Internal Revenue Service (Service) to issue guidance under § 457,
which applies to nonqualified deferred compensation plans of state and local
governments and tax-exempt entities, concerning the definitions of a bona
fide severance pay plan under § 457(e)(11) and concerning
the definition of substantial risk of forfeiture under § 457(f)(1)(B).
This notice also describes the guidance that the Treasury and the Service
anticipate issuing, which in many respects would be similar to the rules in
the recent final regulations under § 409A, and requests comments
on the issues intended to be addressed by such guidance.

II. BACKGROUND

Section 457 applies to nonqualified deferred compensation plans established
by state and local government and tax-exempt employers. Three types of nonqualified
deferred compensation plans are subject to § 457: (1) an eligible
§ 457(b) plan established by a state or local government employer;
(2) an eligible § 457(b) plan established by any other tax-exempt
entity that is not a governmental entity; and (3) any other deferred compensation
plan established by either type of employer (an ineligible nonqualified deferred
compensation plan). An ineligible nonqualified deferred compensation plan
is subject to § 457(f). Section 457(f)(3)(A) provides that the
term plan includes any agreement or arrangement.

Section 457(e)(11) states that § 457 does not apply to certain
types of plans, including a bona fide severance pay plan.
Section 457(f)(2) provides that the rules of § 457(f) do not apply
to a qualified plan under § 401(a) or § 403(a), a § 403(b)
annuity, a nonqualified annuity described in § 403(c), that portion
of any plan which consists of a transfer of property described in § 83,
that portion of any plan which consists of a trust to which § 402(b)
applies, a qualified governmental excess benefit arrangement described in
§ 415(m), or that portion of any applicable employment retention
plan described in § 457(f)(4).

Section 457(f)(1) provides that compensation under a nonqualified deferred
compensation plan subject to § 457(f) is included in the gross income
of the participant or beneficiary for the first taxable year in which there
is no substantial risk of forfeiture of the rights to such compensation.
Section 457(f)(3)(B) provides that the rights of a person to compensation
are subject to a substantial risk of forfeiture if such person’s rights
to such compensation are conditioned upon the future performance of substantial
services by any individual. Any amount deferred under a § 457(f)
plan that is not subject to a substantial risk of forfeiture (i.e.,
a vested amount) is currently included in gross income (even if not actually
or constructively received), and the amount subsequently paid or made available
is taxed under § 72. See § 1.457-11(c).

Section 409A applies to ineligible nonqualified deferred compensation
plans maintained by tax-exempt and governmental employers, as well as to nonqualified
deferred compensation plans maintained by taxable employers. Section 409A
generally provides that, unless certain requirements are met, amounts deferred
under a nonqualified deferred compensation plan for all taxable years are
currently includible in gross income to the extent not subject to a substantial
risk of forfeiture and not previously included in gross income. Section 409A(d)(4)
provides that the rights of a person to compensation are subject to a substantial
risk of forfeiture if such person’s rights to such compensation are
conditioned upon the future performance of substantial services by any individual.

Section 409A does not apply to qualified plans (as defined under § 219(g)(5),
without regard to subparagraph (A)(iii) thereof), eligible deferred compensation
plans under § 457(b), or qualified governmental excess benefit arrangements
described in § 415(m). See § 1.409A-1(a)(2). However,
§ 409A applies to nonqualified (ineligible) deferred compensation
plans to which § 457(f) applies, separately and in addition to the
requirements applicable to such plans under § 457(f). See § 1.409A-1(a)(4).
Section 409A(c) provides that nothing in § 409A prevents the inclusion
of amounts in gross income under any other provision of the Code or any other
rule of law earlier than the time provided in § 409A. Section 409A(c)
further provides that any amount included in gross income under § 409A
is not required to be included in gross income under any other Code provision
or any other rule of law later than the time provided in § 409A.

Final regulations under § 409A were published on April 10,
2007 (72 FR 19234) and generally become applicable January 1, 2008.[1] Those regulations provide guidance on when a separation pay plan
(as defined in § 1.409A-1(m)) is treated as not providing for a
deferral of compensation for purposes of § 409A. See § 1.409A-1(b)(9).
The regulations also define a substantial risk of forfeiture for purposes
of § 409A. See § 1.409A-1(d).

III. BONA FIDE SEVERANCE PAY PLANS UNDER § 457(e)(11)

The Treasury and the Service anticipate issuing guidance providing that
an arrangement is a bona fide severance pay plan under
§ 457(e)(11), and thus is not subject to the requirements of § 457,
if: (1) the benefit is payable only upon involuntary severance from employment,
(2) the amount payable does not exceed two times the employee’s annual
rate of pay (taking into account only pay that does not exceed the maximum
amount that may be taken into account under a qualified plan pursuant to § 401(a)(17)
for the year in which the employee has a severance from employment), and (3)
the plan provides that the payments must be completed by the end of the employee’s
second taxable year following the year in which the employee separates from
service. With respect to the requirement that benefits be payable only upon
involuntary severance from employment, it is anticipated that the guidance
would include exceptions for window programs, collectively bargained separation
pay plans, and certain reimbursement or in-kind benefit arrangements (similar
to the exceptions in § 1.409A-1(b)(9)(ii), (iv), and (v)).

IV. SUBSTANTIAL RISK OF FORFEITURE UNDER § 457(f)

The Treasury and the Service further anticipate issuing guidance regarding
a substantial risk of forfeiture for purposes of § 457(f)(3)(B)
under rules similar to those set forth under § 1.409A-1(d).

Section 1.409A-1(d) provides that a right to an amount of compensation
is subject to a substantial risk of forfeiture if entitlement to the amount
is conditioned on the performance of substantial future services or the occurrence
of a condition that is related to a purpose of the compensation and the possibility
of forfeiture is substantial. For this purpose, if a service provider’s
entitlement to the amount is conditioned on the occurrence of the service
provider’s involuntary separation from service without cause, the right
is subject to a substantial risk of forfeiture if the possibility of forfeiture
is substantial. An amount is not subject to a substantial risk of forfeiture
merely because the right to the amount is conditioned, directly or indirectly,
upon refraining from the performance of services. Further, as described in
§ 1.409A-1(d)(1), the addition of any risk of forfeiture after the
right to the compensation arises, or any extension of a period during which
compensation is subject to a risk of forfeiture (sometimes referred to as
a “rolling risk of forfeiture”), is generally disregarded for
purposes of determining whether such compensation is subject to a substantial
risk of forfeiture under § 409A.

Section 1.409A-1(d)(1) provides that an amount is not considered
subject to a substantial risk of forfeiture beyond the date or time at which
the recipient otherwise could have elected to receive the amount of compensation,
unless the present value of the amount made subject to a risk of forfeiture
is materially greater than the present value of the amount the recipient otherwise
could have elected to receive absent such risk of forfeiture. This is because,
absent tax considerations, a rational participant normally would not agree
to subject a right to amounts that may be earned and payable as current compensation,
such as salary payments, to a condition that subjects the right to the same
payments to a real possibility of forfeiture. Accordingly, in this situation,
agreement to subject the amount to a substantial risk of forfeiture indicates
that the recipient of the compensation is confident that there is not a real
risk of forfeiture and is only subjecting the amount to the purported risk
of forfeiture as a means of avoiding taxation. Thus, amounts that an individual
could have elected to receive under a salary deferral election generally cannot
be made subject to a substantial risk of forfeiture under the rules of § 409A
beyond the date or time the salary would otherwise have been received.

The Service and Treasury anticipate that upcoming guidance under § 457(f)
will generally adopt the rules relating to substantial risk of forfeiture
that are contained in § 1.409A-1(d).

As noted above, § 1.409A-1(d) provides that an amount of compensation
is subject to a substantial risk of forfeiture if the entitlement to the amount
is conditioned upon the occurrence of a condition related to a purpose of
the compensation, and the possibility of forfeiture is substantial. Section
1.409A-1(d) further provides that a condition related to a purpose of the
compensation must relate to the service provider’s performance for the
service recipient or the service recipient’s business activities or
organizational goals (for example, the attainment of a prescribed level of
earnings or equity value of completion of an initial public offering). Comments
are requested on whether any special rules should apply for purposes of § 457(f)
with respect to this aspect of the definition of a substantial risk of forfeiture,
taking into account that state and local government and tax-exempt entities
to which § 457(f) applies generally do not have business activities
or organizational goals that are comparable to profit-making entities.

V. INTERACTION OF §§ 409A AND 457(f) UNDER ANTICIPATED
STANDARDS

Under the rules at § 1.409A-1(b)(4)(i) relating to short-term
deferrals, a deferral of compensation for purposes of § 409A does
not occur if the plan under which a payment is made does not provide for a
deferred payment and the service provider actually or constructively receives
such payment on or before the first day of the applicable 2½ month
period. Under § 1.409A-1(a)(4), the inclusion in income of an amount
under § 457(f) is treated as a payment of the amount for purposes
of the short-term deferral rule contained in § 1.409A-1(b)(4).

If the standard for a substantial risk of forfeiture for purposes of
§ 409A described in Part IV of this notice is adopted, a substantial
risk of forfeiture under § 457(f)(1)(B) could not lapse later than
the date the substantial risk of forfeiture lapsed under § 409A
and § 1.409A-1(d). Accordingly, if a participant under an ineligible
plan under § 457(f) included an amount of deferred compensation
in gross income when it ceased to be subject to a substantial risk of forfeiture
under § 457(f), the amount generally would not be subject to § 409A
because the right to the amount and the payment would qualify as a short-term
deferral under § 1.409A-1(a)(4). However, the right to earnings
on amounts that have previously been included under § 457(f) would
be deferred compensation for purposes of § 409A unless the right
to the earnings independently satisfied the requirements for an exclusion
from coverage under § 409A.

VI. EFFECTIVE DATE AND RELIANCE

The Treasury and the Service anticipate that the guidance described
in this notice would be prospective. With respect to periods before such
guidance is issued, no inference should be made from the anticipated guidance
described in this notice regarding either the definition of a bona
fide severance pay plan for purposes of § 457(e)(11)(A)(i)
or the determination of substantial risk of forfeiture for purposes of § 457(f).
However, pending the issuance of further guidance, taxpayers may rely on
the definition of a bona fide severance pay plan in the
anticipated guidance described in section III of this notice for purposes
of § 457(e)(11)(A)(i) and the rules regarding a substantial risk
of forfeiture in the anticipated guidance described in the first two paragraphs
of section IV of this notice for purposes of § 457(f). Comments
are specifically requested as to the extent to which transition guidance regarding
the application of § 457(f) would be necessary and appropriate,
and what such transition guidance would provide.

This notice does not affect the application of § 409A or the
guidance thereunder, including the determination of whether a plan is subject
to § 409A and the application of the transition guidance issued
under § 409A.

VII. REQUEST FOR COMMENTS

Treasury and the Service intend to issue guidance reflecting the definitions
of a bona fide severance pay plan for purposes of § 457(e)
and substantial risk of forfeiture for purposes of § 457(f), as
described in Parts III and IV of this notice. Comments regarding these definitions,
and any related issues that should be addressed under § 457, are
requested.

VIII. DRAFTING INFORMATION

The principal author of this notice is Cheryl Press of the Office of
Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities).
However, other personnel from the Treasury and the Service participated in
its development. For further information regarding this notice, contact Ms.
Press at (202) 622-6060 (not a toll-free call).

[1] For general and transition guidance regarding the application of § 409A,
see Notice 2005-1, 2005-2 C.B. 274, and Notice 2006-79, 2006-43 I.R.B. 763.
See also Notice 2006-100, 2006-51 I.R.B. 1109, which provides guidance to
employers and payers on their reporting and wage withholding for calendar
years 2005 and 2006 with respect to deferrals of compensation and amounts
includible in gross income under § 409A.